title for a 2011 year-end entry

Another year has passed, while a new one begins. Each annual turn is often a time of reflection as well as prediction. In keeping with that tradition, today’s entry will comprise some of the former, but mostly the latter, and some of neither.

The S&P 500 ends the year up about 15%, the Nasdaq about 17% and the Dow 11%. From where I stand, that’s a banner year, especially considering that average annual returns are more like 8-9% and long-term expected returns from today’s levels look to be under 6%. (Thus we can say this one year’s returns represent two years' expected.) Commodities and other risky assets also had a great year. Bonds and stocks, both foreign and domestic, performed well. Commodities, in some cases, knocked it out of the park (think cotton, up 90%). Gold rose about 30%, oil 13%. Housing prices did not do so well, however, and the economy limped along.

So 2010 looked good for the markets. Does that have any relation to a 2011? As we have to disclose often, past performance is not necessarily an indicator of future results. Still, the two are often related. Specifically, past performance can be a contrary indicator of future results. As the saying goes, if something can’t continue, it won’t. I am optimistic about the future overall, but I see several areas that appear stretched and where future results may not be as robust as the recent past.

Today we learned that that Groupon accepted about $500 million of a $1 billion funding round. This is a two-year old company is an industry that doesn’t have a lot of barriers to entry. Sure, they were the first, but their margins are artificially high and their labor-intensive strategy depends a lot on street-level salespeople. There is a lot of panache here; Groupon is cool and retailers want to be associated with them - now. But “cool” is ephemeral and in business competition does not lay down just because you're bigger. Especially when the business model is so easily copied and the space nascent. Competitor LivingSocial has received investment from Amazon and it’s not a stretch to believe my favorite online retailer could move into that market. Yet Groupon is raising a billion dollars. To me, it’s unbelievable and is probably a sign of too-heady times in the private markets.

Meanwhile, the commodities rose still has its bloom on the ever-present investment thesis of increasing consumerism in emerging markets. I think there could be several surprises on the “emerging” front in the new year that will surprise a lot of the gung-ho investors in this space. I speak specifically about gold and rare-earth metals here, but I get the feeling that a lot of the agricultural commodities have run up too high (and so have some of the ag-related stocks). A thesis that makes sense at a price does not make sense at any price.

Oil seems fairly priced to me at present.

As for stocks, a previous post pretty well elucidates my thoughts here. Bonds are something I’ve also recently written at length about and my feelings here haven’t changed a whole lot. I think surprises to the downside on bonds and stocks await. Put premiums are low as markets near their recent highs amid high levels of investor bullishness. This tends to be the case near market peaks.

Are there any bubbles (other than in the use of the word “bubble”)? I think there is one in concerns over our fiscal and monetary situation. That is a funny thing to say because I, too, am concerned. It just seems to me that “everyone” is concerned about these two things and so they are probably somewhat overblown. Such things have a way of working themselves out. While it’s often felt that the good folks in Washington live in a different world, I’m not convinced they won’t take care of these problems. A year ago, I wouldn’t have dreamed Obama would break his campaign promises by passing a law that was largely deferential to Republicans. But it doesn’t take much to change Washington’s mind and/or direction these days and our problems will not just get worse in a linear fashion. However, fiscal and monetary issues should lead investors to plan for contingencies, protecting from downside deviation.

The solutions aren’t linear, either. Think protection from phase transitions, or more popularly, tipping points. Securities trading below intrinsic value. Healthy balance sheets. Excess cash. Opportunistic management teams with flexible operating philosophies. Don’t try and time the market, but be ready to pounce when Mr. Market turns manic.

Most of the economic data coming out is noisy. The bottom line is the economy isn't going gangbusters and I'd expect that activity would remain at a similar pace. Of course, that's the easiest expectation. Unemployment just can't come down as fast as we'd all like without some significant retraining and job creation in other sectors. It’s a structural issue which will take years to resolve. At the same time, corporate profit margins are well above their historic highs.

2010 was a fantastic year, personally as well as professionally. Each day is a chance to learn something new and I'd like to think I was able to do so. I hope 2011, despite its being an odd year, holds similar promise. Happy New Year.

the stock market ahead

In 2011, I don't think the stock market deserves to rally. Now, that doesn’t mean it won’t. (To be any good at making predictions, I must hedge.)

I see a few things. Abundant in the media are calls for stocks to rise and bonds to fall, with stocks being cheap. But why can’t stocks and bonds be expensive concurrently? Money will move out of bonds, so the story goes, and into stocks, making one less expensive and the other moreso. (One of my) problem(s) with this is that money flows don’t really tell the story. The stock market is simply trading of already-offered shares held by others. The company is not involved (excluding share buybacks and recaps). When A sells his shares he must sell to B, who pays money to A. B then owns shares and A holds cash. As John Hussman has pointed out, the fact that A brings his cash into the market doesn't make prices go up, since no cash has actually been added to the market. Instead of A holding shares, B holds them. The same amount of cash is “on the sidelines.” It is the eagerness of the buyer (or seller) that makes prices fluctuate, as stock prices are priced on the marginal trade. Okay, that was a little long to make the point but I think it was necessary.

When I look at stocks broadly speaking (S&P 500 Index) today, I see a market that discounts decade-ahead total returns of just under 6% over the next decade. Since returns tend to be more stable when predicting for longer periods of time, I am most comfortable with this 6%-for-the-decade number. But I’ll list a few others. Five year: 4.5%. Three year: 1.6%. One year: -8.9%.

(A couple things to note here: these numbers are based on my calculation of the intrinsic value of the market and include the current S&P 500 dividend yield of 1.89%. Intrinsic value is based on normal earnings, which use numbers representing long-term averages for earnings growth rates, returns on equity and cost of capital.)

What these numbers tells me is that over a decade returns might end up decent, but not spectacular given the potential drawdowns inherent to stock markets. And it also says if your time horizon is shorter than five years, return prospects don’t look to spectacular (negative on a price-change basis for one- and three-year periods). To use a holiday metaphor, these returns look like a fruit cake. I'd rather have sugar cookies.

It’s always best to judge each asset class relative to the cafeteria menu of available investment options. On that front, bonds don’t look much better. A ten-year Treasury yields 3.3% today, not spectacular and especially with a duration close to 7 certainly not worth a large risk, again, on a risk-adjusted basis. Shorter-term bonds seem the best place to reduce risks in this space - the most salient of which appears to be reinvestment risk. Too, interesting opportunities are emerging in municipal bonds. I may expound on this later.

start-up-tomism

It strikes me today that optimism in the professional investment community remains at a relatively low level. Why? Out-of-control government spending. The $1.4 trillion federal deficit. $13 trillion in national debt. Eurozone economic concerns and the implications for the future of the euro currency. Not to mention the Federal Reserve’s actions which could spur inflation. The potential for an abrupt rise in interest rates. Rising commodity prices. The rise of China and India as competitors to the U.S. An equity market still meaningfully below its 2007 highs.

Many of the above are valid concerns and indeed are areas that need work. The equity markets today are implying decade ahead returns around 5%, certainly not a place to take unmitigated risk. Interest rates are low (but rising), benefiting borrowers/spenders at the expense of savers. The volume of the above factors is loud and the focus on them disproportionately high among investors and the public at large. They can lead us to forget a couple of things.

First, most of them we can’t control. We simply can’t, other than through elected officials, reduce government spending. We can, however, get ourselves into better financial shape through our own actions and position ourselves for worse economic times through higher savings, for instance.

Furthermore, these things tend to work on one way or another. Let’s take it to the extreme and say that government debt continues to rise and short-term interest rates go to 10.0%. With the government rolling over roughly a third of its total debt each year we’re looking at another $300 billion in interest expenses each year just on short-term debt. Say we print money and devalue the dollar in world markets to pay for this extra debt. Interest rates rise across the country, prices rise for consumers and unemployment rises dramatically. We couldn’t have stopped it, but we could have assets invested and liquid assets available to ameliorate the personal impact. Okay, enough of that since it detracts from what I’m really trying to say.

That is, in the fog of our short-term focus on the above issues and the maddening tendencies of the media to bloviate about them 24/7, we forget the ingenuity of the U.S. spirit and what’s going on in the entrepreneurial community today.

At this point, startups are being created like wildfire and funding is rabid. Several prominent venture capitalists have declared that there could be a bubble forming in early-stage technology companies, especially so-called Web 2.0 companies. I’ve heard many write and speak about the prices at which early funding rounds are taking place. Apparently, they’re not grounded in reality at this point and to some it “feels” like 1998-1999 again. (However, there are certain fundamental differences that differentiates this period from then. I may touch on this at a later date, but it mostly relates to valid business models and actual earnings.)

Anecdotally, it’s becoming more prevalent to see local articles about new companies being started dealing with the tech space. I’m encouraged by these signs. Let me point out that first and foremost I am a value investor. I try and figure out the stream of cash flows (both positive and negative) that can be expected over the life of an investment and discount it at an appropriate interest rate. Startups don’t have the luxury of much visibility on this front and so I haven’t (not yet, at least) invested in them. Also, I understand macro and micro-economics that makes me reticent about trying to pick winners.

Surely, there is no way that all startups receiving attention and/or funding today can reach the level of the most popular examples – such as Groupon, Twitter and Facebook. It doesn’t work like that. Many, if not most, won’t survive another year. As Warren Buffett has said, first come the innovators, then the imitators, then the idiots. Probably a lot of the incremental funding is coming from those in the third category and when the level of sophistication falls, so does the quality of the overall pool.

My broader point can get lost in the micro discussion, so I’ll finish here. Just because the effects of competition will ensure that most of these businesses fail (90% as goes the statistic?), the activity speaks to an entrepreneurial spirit that is alive and well in this country. And it’s a spirit that will endure in spite of the broad economic, fiscal, and monetary concerns that receive disproportionate attention in media coverage.

no sabbatical excuse

I wish I could say I was on sabbatical this past year but that hasn't been the case. I simply haven't put enough effort into getting a few thoughts down "on screen" on a regular basis. I intend to remedy that.

I intend to write a bit more frequently after a hiatus that comes down mostly to reticence in sharing new investment ideas, as was the prior focus. With growing compliance concerns in the investment industry and given the inherent competitiveness of the market I cannot often write about original ideas I’m pursuing. Though I will certainly comment on specific companies I will not necessarily do so often, especially those I own for myself or clients. Nor will I present performance information of any type, as has always been my penchant. In fact, I intend to sometimes put down ideas that are only tangentially - or not at all - related to investing, but interesting nonetheless.

Concurrent with more frequent writing comes a couple thoughts:

(1) It can be a waste of time to do extensive editing to text, so expect some grammatical and spelling flaws to emerge from time to time (or just all the time). People generally understand the point without it being encased in perfect prose and spelling, each of which aren’t immutable anyway.

(2) Writing a blog on a frequent basis comes within the context of a busy schedule. Against this backdrop, just getting something type and posted is as remarkable as what is actually written. Still I hope, but can’t promise, that each post is worthwhile and presents at least a new kernel of insight that makes my comments worth reading. I fully realize this a difficult standard, but I will do my best to meet it.